History

Congress introduced the “credit for increasing research activities” as part of the Economic Recovery Tax Act of 1981. “The credit was intended to `stimulate a higher rate of capital formation and to increase productivity'” by incentivizing taxpayers to undertake new research. In general, the credit was equal to a percentage of the amount by which a taxpayer’s “qualified research expenses” or “QREs” for the credit year exceeded its average QREs for the three preceding tax years. Consistent with its name, therefore, the credit rewarded taxpayers who increased their research expenditures year over year. 

In the years following its enactment, Congress extended the credit multiple times and, in at least one instance, allowed it to expire for a year before reinstating it prospectively. When we say that Congress “extended the credit,” we mean that Congress made the benefit applicable to expenses incurred in a period not originally covered by the statute.  Without these extensions, taxpayers would not have been entitled to any research credit in years following 1986 for incurring the types of expenses the credit is intended to incentivize. Congress finally made the research credit permanent in 2015. 

Congress also modified the research credit a number of times after its initial enactment, including by moving the credit to different Code sections, changing the primary method of calculating the credit, and adding new methods for calculating the credit, each on more than one occasion. 

Research Credit

Section 38 permits a taxpayer to report on his return a credit against tax equal to current year business credits. Current year business credits include the credit under section 41 for increasing research activities.

In the case of an S corporation, the amount of a claimed section 41 credit is allocated among the shareholders pro rata. Each S corporation shareholder may then claim the section 41 credit on his or her income tax return in an amount “equal to the amount of tax attributable to that portion” of the taxable income “allocable or apportionable” to their shareholder interest. To the extent an S corporation shareholder’s pro rata portion of the section 41 credit for the taxable year exceeds this limitation, that shareholder may carry forward the unused amount of credit to a future taxable year.

Section 41 describes five methods for calculating the research credit, some that operate as alternatives to each other and some that work in tandem. Each method is different from the others in various respects, but consistent with the credit’s original design, nearly all the methods include a mechanism to reward taxpayers who increase their research activity in the current year relative to some earlier baseline defined by the statute.

Most small-mid size business use the alternative simplified method. Like the original method for calculating the credit adopted in 1981, the alternative simplified method generally requires a taxpayer to compare its current year QREs to those it incurred during the three preceding years. So, a taxpayer that increases its QREs in the current year relative to the three preceding years generally gets a larger credit. And the calculation of a taxpayer’s three preceding years can significantly affect the final credit amount.

To understand the research credit, you must navigate a complex web of statutory definitions. We will try to explain each definition without losing sight of the broader calculation of the research credit.

Alternative Simplified Method

Under the alternative simplified method, the research credit is equal to 14% of the excess of the taxpayer’s QREs in the credit year over 50% of the average of the taxpayer’s QREs from the three preceding years. If the taxpayer has no qualified research in each of the three preceding years, the credit is reduced to 6% of the taxpayer’s QREs in the credit year.

QREs

QREs are the sum of “in-house research expenses” and “contract research expenses” “paid or incurred by the taxpayer during the taxable year in carrying on any trade or business.” Most small-mid size businesses only include in-house research expenses in QREs because most small-mid size businesses do not have contract research expenses.

In-House Research Expenses

In-house research expenses are “any wages paid or incurred to an employee for qualified services performed by such employee” and “any amount paid or incurred for supplies used in the conduct of qualified research”. 

Qualified Services

Qualified services are defined as engaging in qualified research or engaging in the direct supervision or direct support of qualified research. Generally, wages are considered in-house research expenses to the extent that the wages were paid for qualified services of an employee.

Direct Supervision

Direct supervision means the immediate supervision of qualified research, such as a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments. Direct supervision does not include supervision by a higher-level manager even if that manager is a qualified research scientist.

Direct Support

Direct support as services in the direct support of either persons engaging in actual conduct of qualified research or persons directly supervising persons engaged in actual conduct of qualified research.

Qualified Research

Under section 41, four requirements must be met in order for an activity to be “qualified research.” 

‘First, the research expenditures must be eligible to be treated as expenses under section 174. We refer to this as the “section 174 test,” whereby the taxpayer must show that the research activities constituted research and development within the meaning of section 174, and that the research expenditures would be eligible for deductions under section 174.

We apply a two-step test to determine whether a taxpayer’s activities constituted research and development within the meaning of section 174. In the first step the taxpayer must show that the information objectively available to it did not establish the appropriate design of the product. If such information was not available to the taxpayer with respect to establishing either the capability, method, or appropriate design, then uncertainty existed. In determining whether uncertainty existed, we examine the information objectively available to the taxpayer, rather than the taxpayer’s subjective understanding of that information.

In the second step, if uncertainty existed, the taxpayer must show that it undertook investigative activities that were “intended to discover information that would eliminate uncertainty.”

If a taxpayer shows that the research activities constituted research and development within the meaning of section 174, the taxpayer must then show that the expenses related to these activities are deductible under section 174.  

Second, the research must be undertaken to discover information which is “technological in nature.” We refer to this as the technological information test.

Information is technological in nature if “the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.” The technological information test does not require the taxpayer to rely on novel applications of science.  Instead, a  taxpayer may rely on existing principles of science and engineering to satisfy this requirement.  

Third, the application of that research must be “intended to be useful in the development of a new or improved business component of the taxpayer.” We refer to this as the business component test.

A business component is “any product, process, technique, formula, or invention” which is to be held for sale or used by the taxpayer in its trade or business.

After a taxpayer establishes which business component it sought to develop, the business component test requires that the taxpayer intend for the discovered information to be useful in developing a new or improved business component of the taxpayer. To be useful within the meaning of this test, the research need only provide some level of functional improvement to the taxpayer.

Fourth, “substantially all of the activities of” the research must “constitute elements of a process of experimentation for a purpose” related to “a new or improved function,” “performance,” or “reliability or quality.” We refer to this as the process of experimentation test.

A process of experimentation is a “process designed to evaluate one or more alternatives to achieve a result where the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives. A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.

Exclusion

Certain types of research are specifically excluded from the definition of qualified research. They include research conducted after the beginning of the commercial production of a business component, research related to the adaption of an existing business component to a particular customer’s requirement or need, foreign research, research in the social sciences, arts, or humanities, and funded research.

The Process for Small-Mid Size Businesses

First, a small-mid size business will identify research activities. Second, the four-part test is applied to each research activity to determine whether a taxpayer performed qualified research. Finally, once the four-part test for qualified research is satisfied for research activities, then QREs are determined.

QREs and In-House Research Expenses (again) 

As previously mentioned, QREs are defined as the sum of a taxpayer’s in-house research expenses and contract research expenses. In-house research expenses include the wages paid or incurred to an employee for qualified services performed by the employee. If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense. If substantially all of the services performed by an employee during the taxable year consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research, the term “qualified services” means all of the services performed by the employee during the taxable year. The “substantially all” threshold is satisfied with respect to an employee if the wages appropriately apportioned to qualified research services constitute at least 80% of the wages paid to or incurred by the taxpayer for the employee during the taxable year.

The amount of wages properly allocable to qualified services is determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the employer to the total time spent by the employee in the performance of all services for the employer during the taxable year.

Credit Calculation

Once QREs are determined, a taxpayer is ready to calculate the research credit. Under the alternative simplified method, the research credit is equal to 14% of the excess of the taxpayer’s QREs in the credit year over 50% of the average of the taxpayer’s QREs from the three preceding years. If the taxpayer has no qualified research in each of the three preceding years, the credit is reduced to 6% of the taxpayer’s QREs in the credit year.

Example 1 – Small Business with Qualified Research in Prior Years

Identify the Inputs

Current Year QREs: $1,000,000

3-Year Average QREs: $1,000,000

Calculate the Base Amount

Base Amount = 50% of the 3-year average QREs

Base Amount = $1,000,000 x 50% = $500,000

Calculate Excess QREs

Excess QREs = Current Year QREs – Base Amount

Excess QREs = $1,000,000 – $500,000 = $500,000

Compute the Research Credit

Research Credit = 14% x Excess QREs

Research Credit = $500,000 x 14% = $70,000

The Total Calculated Research Credit is $70,000

Example 2 – Small Business with No Qualified Research in Prior Years

Research Credit = Current Year QREs x 6%

Research Credit = $1,000,000 x 6% = $60,000

The Total Calculated Research Credit is $60,000